This paper reviews Korean thin capitalization rules in the context of
comparative and international law, and further analyzes the relation between thin
capitalization rules and tax treaties. The thesis of the paper is that the thin cap
rules do conflict the language and structure of typical tax treaties which adopted
the language of the OECD model treaty, although the OECD Model Commentary
does not admit the conflict. First, the arm’s length principle as it applied to the
thin cap situation would require the lender to demand more interest from the
debtor, and would reduce the taxable income of the debtor. The OECD argument
that an unrelated party would not lend money at all is inconsistent with the
arm’s length principle, which, for example, does not deny a related party license
and instead merely adjusts the royalty rate. Second, the thin cap rules are
inconsistent with the treaty obligation of non-discrimination between foreign and
domestic lenders, because the very essence of the rules consists of discriminatory
disallowance of interests paid to foreign lenders. The Commentary justifies the
rules again by reference to the arm’s length principle, which, however, does not
solve the problem as discussed above. Third, the rules are also inconsistent with
the obligation of non-discrimination of foreign-invested companies vis-a-vis
domestic-held companies. The Commentary argues that this obligation is trumped
by the aforementioned non-discrimination, but this argument is wrong in that the
two obligations have different coverages. The paper ends with the observation
that the thin cap rules were overtly and covertly overriding tax treaties for about
three decades, but are now being swept away by freedom of establishment under
EU law.